Does foreign real estate qualify for a 1031 exchange?

Dateline: Los Angeles, United States

For years, real estate agents here the United States have touted the benefits of using tax-friendly 1031 exchanges. Few places have seen more frantic investors than right here in real estate-happy Southern California.

Indeed, if you own rental property that is declining in value in the high-tax United States and want to sell it only to buy more bad US real estate, a 1031 exchange can be helpful.

While such tax tricks are useful, they aren’t necessary if you embrace the higher probability investment that is foreign real estate.

Not only can foreign real estate be the impetus to obtain a second residency and passport in another country, it is typically a superior investment to your domestic options.

Whether you want a high-yield investment or just property to hold as a store of value, I believe overseas real estate can be a much better addition to your global portfolio.

Not to mention the fact that foreign real estate is an easy way to avoid capital controls, and property held in your own name as a US person is non-reportable (income from such property, of course, is).

However, many people have asked, “can I use a 1031 exchange for foreign real estate holdings?”

First, let’s look at what a 1031 exchange is…

A 1031 like-kind exchange is a part of the U.S. tax code that allows for investment property, real estate or otherwise, to be exchanged for similar investment property. You can exchange a piece of factory equipment for another piece of factory equipment… or you can exchange a commercial building for a residential apartment building.

That means investment real estate for investment real estate.

The great thing about a 1031 exchange is the massive tax savings. Many don’t realize this can apply to foreign real estate transactions as well as US-based ones.

The rules are that you can transfer a like-kind property — foreign to foreign or US to US. For example, you can transfer a piece of land in Ecuador for an apartment building in Singapore, but you can’t transfer a house in Ohio for a duplex in Dubai.

Another rule that applies in a 1031 exchange: No touching the proceeds of a sale. In other words, you can’t transfer them to your bank account. You will need a qualified intermediary to hold the proceeds, and then transfer them to the seller of the new property.

The foreign real estate 1031 exchange can sound like a great deal in theory. But is it?

Not always.

Let’s say you were selling a property in France, where capital gains taxes are notoriously high, and you were planning to exchange it for a property in Texas.

If you are paying 20% in taxes to the US, you may be better off just paying the French extortion fee and writing that off against your taxes. In the long run, you just saved money.

On the other hand, if the country you are selling your property in has no capital gains taxes (i.e. New Zealand, Belgium, Malaysia), then you are better off with a tax-deferred 1031 exchange.

Why would you want to buy property out of the US?

For one, it’s a good idea to get off a sinking ship while you can, and get into one that’s rising with the tide.

It’s also important to diversify your holdings. All-in with one part of the world is a risky proposition.

Of course, you may also be looking for more freedom in another part of the world.

That may be the ultimate knock against US real estate.

Where are some good places to invest in real estate?

There are so many opportunities around the world when it comes to investing in real estate. Here are a few ideas:

Great places to use your 1031 exchange offshore

Nicaraugua. The property market in some of the coastal towns is fairly well-developed and very easy for renting places out to vacationing North Americans via a property manager. The risk of expropriation is also extremely low, and it’s still a bit of a contrarian move, making prices low due to the perceived danger in this country.

Lithuania. I’m not a huge fan of EU countries, but the rise of the Baltic states is intriguing, and Lithuania offers some of the best opportunities in European real estate. As Lithuania will be adopted into the EU in January 2015, real estate prices will likely rise 20-30% in the early stages, with even bigger potential growth in the coming years. Investing now will be a great appreciation play.

Cambodia. This up and coming centrally located Asian country has a big upside and a very small downside. When I visited the country, my interest was in its rural areas. Between the implementation of a strong title system and the development of irrigation, it won’t be long before property values begin to rise with the coming advancements.

The opportunities internationally are tremendous for trading in your US real estate and getting into growth rather than decline. Instead of focusing on leaving communist California for less-communist Texas, working the 1031 exchange system can offer you more upside promise into greener, freer pastures.